Sunday, 13 July 2008

Freddie and Fannie - a bailout next week

There must an army of people in Washington working this weekend. Markets have lost confidence in Freddie Mac and Fannie Mae. Everyone agreed that both government sponsored companies are close to insolvency. "Something" must be done, and that "something" will be a committment from the US government to cover the losses of two two troubled US institutions. Officials are almost certainly working out the details over the weekend.

Last week marked the beginning of the biggest financial bailout in history. The US taxpayer will foot the bill for housing crash in at least three ways. The senate passed an ill-advised bill that will insure some $300 billion of subprime losses. The US deposit insurance agency - the FDIC - will pick up the tab arising from failed banks. The first major failure happened on Friday, when the FDIC took over IndyMac.

Then, the government will have to sort out Freddie and Fannie. The US government have a few options here. It could guarantee the liabilities of both institutions, it could nationalize it, or it could simply inject capital. However, all three methods, or any combination thereof, will be extremely expensive. The costs will turn up in the US public sector debt numbers.

The US is already a heavily indebted country. It also has serious long term fiscal liabilities arising from its social security system. The bailout could easily push US public debt above 100 percent of GDP, putting the world's largest economy on the same footing as Italy and Argentina.

Here in the UK, as we watch the unfolding financial catastrophe in the US, we should be shaking with fear. The US housing bubble was more modest than ours; while their banks have recognised their losses more rapidly. The UK housing crash has barely begun.